Like All Bubbles, This One Will End Badly

Crashes always seem to come out of nowhere. But, in hindsight, we realize that all the elements for a crash were in place months before prices fell.

Stock market crashes always seem to come out of nowhere. But, in hindsight, we realize that all the elements for a crash were in place months before prices fell. There will, of course, be another crash, and we can already see many of the black swans lining up to cause the crash.

A black swan is a rare event that no one seems to be able to predict. It could be a housing crash after prices soar to unsustainable levels and are propped up by lax mortgage-underwriting standards. Or a black swan could be a surge in inflation or a geopolitical crisis.

When we study the black swans after the fact, they seem obvious. There were clues, but investors ignored the clues because they were caught up in “irrational exuberance.” Sometimes, investors can remain irrational for years. That’s what happened in 1996, the last time Alan Greenspan issued a warning.

Greenspan was chairman of the Federal Reserve at the time. He famously asked: “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

Analysts at the time thought Greenspan was warning of a stock market bubble. He was, but the bubble lasted until early 2000, and the S&P 500 more than doubled before the bubble popped. Internet stocks recorded even bigger gains.

This time, Greenspan thinks we’re in a different kind of bubble…

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The Bubble Will Burst

For now, Greenspan thinks the stock market is in good shape. But he believes higher interest rates will cause a bear market someday.

Greenspan recently spoke to Bloomberg and confirmed what almost everyone who isn’t in the Fed believes: “By any measure, real long-term interest rates are much too low.”

In his view, bonds are in a bubble. And like all bubbles, this one will end badly.

“The real problem,” he said, “is that when the bond-market bubble collapses, long-term interest rates will rise. We are moving into a different phase of the economy — to a stagflation not seen since the 1970s. That is not good for asset prices.”

Many of us are too young to remember what the stock market was like in the 1970s. The chart below shows Greenspan was right. It was not a good time for asset prices, and investors suffered large losses.

Crashes always seem to come out of nowhere. But, in hindsight, we realize that all the elements for a crash were in place months before prices fell.

The early 1970s was a time of relatively low inflation. The annual change in the Consumer Price Index is the red line in the chart below. The blue line shows the interest rate on 10-year Treasury notes.

Inflation jumped suddenly in 1973, and the Fed was slow to react. It kept interest rates too low for too long, and inflation roared toward 15%.

Crashes always seem to come out of nowhere. But, in hindsight, we realize that all the elements for a crash were in place months before prices fell.

(Source: Federal Reserve)

Eventually, the Fed raised interest rates and broke the inflationary spiral. But consumers endured high unemployment and high inflation while the Fed learned to battle inflation.

Maybe this time is different, and the Fed won’t allow inflation to accelerate. But that seems unlikely. We already have half of the stagflation formula in place with a stagnant economy.

Greenspan is warning that an unexpected spark will set off inflation. He’s probably right, because the Fed is in uncharted territory and has created a bubble in bonds. The bubble will burst … we just don’t know when. We do know, as Greenspan notes, that that will not be good for asset prices.

Regards,

Michael Carr, CMT
Editor, Peak Velocity Trader

  • Thomas Waldenfels

    “A black swan is a rare event that no one seems to be able to predict.”

    No, a black swan is a COMPLETELY unpredict-able event. No “seems” about it. Even if you’re really smart and try really hard, you won’t be able to see it coming.

    The housing crash was absolutely predictable and the 2007-2010 crash was, indeed, predicted by at least a couple of dozen people I follow.

    A surge in inflation? Nope. Not a black Swan. A geopolitical crisis? Not really, unless it truly comes out of the blue and is on no one’s radar. The outbreak of the Plague was a Black Swan. The asteroid that killed the dinosaurs was a black swan. A geopolitical example: An Air Force bomber broke apart over Goldsboro N C., releasing two atomic bombs in 1961. Actually happened. They just didn’t trigger. One was recovered. One is still buried in a couple hundred feet of mud

    Anything you can easily imagine is NOT a black swan. You might want to actually read Taleb’s book. What you’re describing is under-appreciated risks.. Different thing entirely. You can’t protect yourself from a black swan directly. You just have to concentrate on making yourself “anti-fragile” to whatever may come along.

  • Patrick Booth

    Thomas – rarely do I read comments that are better than the original story, yours were very enlightening, thanks for sharing.

  • Thomas Waldenfels

    You’re welcome. Thanks for the comment.

    If I might add something … The future is unpredictable, but it makes us feel so helpless to admit our powerlessness in the face of randomness that we unconsciously delude ourselves into thinking we really do understand the threats we face. We don’t. We can’t.

    I see writer after writer failing to understand what a black swan really is, but that doesn’t stop them from speaking with faux authority about the phenomenon. I’ve come to the conclusion that it’s because they can’t imagine the unimaginable. That has them falling back to listing possible threats … even if the odds of their occurring is low … and calling them black swans.

    The lesson of the black swan is that you shouldn’t spend time worrying about what particular event might precipitate a crisis. Look at how how out-of-whack and vulnerable to shock the system is and if it’s as screwed up as this one is, protect yourself and make yourself as invulnerable as you can before the “stable disequilibrium” suddenly becomes an “unstable disequilibrium.”

  • jrj90620

    Seems like today there are no limits on the ability of central banks to issue unlimited amounts of fiat currency.So,I don’t worry about debts in the long run.The debts aren’t real money debts.They are fiat currency debts,which govts can pay/devalue by creating fiat at no cost.I worry about the value of fiat currencies.Currencies are the ultimate bubble and will be the fall guy for bankrupt govts.I think it’s risky to have much % of your wealth in fiat currencies or anything tied to them,like CD’s,bonds,etc.

  • Michael Carr

    You are 100% right – a black swan according to Taleb cannot be predicted. Yet, Paul Tudor Jones did pretty well in October 1987. John Paulson did pretty well in 2008. There are fortunes to be made by spotting the next one. And, I might be looking at the wrong swan but if I’m not, it will pay off in a big way. If I;m wrong, that’s what risk management is all about. Taleb’s book is popular but Ned Davis’ book is a better read. Davis fit everything we need to know about investing right in the title, “Being Right or Making Money.” Given the choice, I pick the latter every time.